Core and Guay et al. (2003: pp43-51) described that the world has witnessed a “new economy period” in which the notion of firm valuations have changed from what has been considered as “empirically supported valuations” to the latest highly inflated “forecasted cash flow valuation model” that is not empirically supported. For example, let us analyse what Enron did in the valuations of their structured finance products in 2001-2002. They signed a 20-year agreement with “Blockbuster Video” (a company that developed technology models of streaming videos) and introduced a new business concept of video on demand that could be launched in the US cities.
They planned to use their optical fibre based infrastructure for broadband networking and created some pilot projects in the cities of Seattle, Salt Lake City and Portland where they provided video streaming services to some apartments from the systems installed in their basements. Based on such pilots, they projected huge cash flows with about USD 110 Million of net profits within a year using the “forecasted cash flow model” to the retail investors. Experts say that the business model was itself baseless because the legal licensing and market demands for such services were not clear.
They raised huge funds by just projecting a business based on pilots and cash flow projections (Healy and Palepu, 2003: p. 3-14). In the old models, well established and successful companies that have proven track records for at least five years, achieve respectable firm value (share prices) if they have been able to sustain their “residual cash” for the past five years and also have been exhibiting sustained growth of income. New companies therefore have to wait until they generate such performance data.
These valuation methods have been based on sound accounting principles and have been widely supported by the past empirical theories. However, in the new economic world, a company or business having a life of less than one year can also achieve high values by virtue of their growth projections, innovations and technological capabilities. The speculators project high growth, high cash flows, attractive potential in the markets, and high value of assets (primarily intangible) to investors and are able to push equity prices upwards.
Such companies begin with a high leverage ratio and are also able to gradually reduce their leverage ratio by generating investment money from the markets, which in turn is spent in the so called high growth projects.
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